Disclaimer: The information provided is not financial, investment, tax or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement or offer to buy or sell any securities or any other financial instruments. For more information read the disclaimer.
Hey Everyone! Today I am touching on an extremely crucial aspect of investing, determining whether the business we are invested in/going to invest in has a sustainable business model. Answering this question helps us understand if we expect the business to last a long term and if the management reinvests in the business in a sustainable way so that the business doesn't go under. I analyze this important question by observing 2 things:
- Rule of 40
- Gross Margins
Let's look at Rule of 40!
One of the most basic metrics used for evaluating SaaS businesses quantitatively is the rule of 40.
The basic intuition with rule of 40 is that the sum of your growth rate and your profit margin should be >=40%.
So if we model this simple rule using various growth rates and profit margins we arrive at the following table.
Observe the yellow part of the table. You can see that for example if you are growing at 30% you can have a profit margin of 10% and can achieve the rule of 40. Similarly, if you are growing at 60% you can lose 20% and still honor the rule of 40. All the data points from the Yellow part of the above table tell us a similar story, the sum of revenue growth and profit margins add up to 40%. So the businesses exhibiting these numbers are healthy.
For growth rates, I usually use revenue growth rates and for profit margins, I use operating margins. You can also use free cash flows, cash flows, EBITDA, and net income margins for profit margins. The right choice depends on the business and your understanding of the business and the cost structure associated with the business.
Now observe the RED portion of the above table. They don't honor the rule of 40(they are below 40%). So what's going on here? You will need to analyze the business to see if they are over-investing in growth(usually a bad sign as they are inefficient businesses) or they are excessively reinvesting money back into the business to grab a huge market share.
From the previous paragraph, if we see a business below the rule of 40 scores, it's safer to avoid that business as an unhealthy business for now and jump back into the business if the numbers improve.
Now, as I discussed earlier there might be a possibility that the business is reinvesting aggressively to capture a large market share. This is a very advanced case and you should have very high confidence in the business, its moat, and the management team before you go down this path to find out whether the rule of 40 <40 is a positive for you.
A few ways to check for reinvestment to grab market share are:
- Are they moving upmarket from SMB to Enterprise?
- An even better indicator is, are they increasing the number of large enterprise customers at a rapid pace?
- Are they landing bigger deals on renewals(shown by the dollar-based net retention ratio)
- Are they actively building out/increasing the number of people in sales?
Again if you can answer these questions reliably and with a high degree of confidence, I would still recommend you to avoid such a business, as the downside risk is too high.
What if the rule of 40 score for the business is greater than 40%? In this case, it's a huge positive. You have on your hand a business that is incredibly efficient in either growth or profitability or both!
The rule of 40 implies that it's okay to lose money in the short term if you are growing fast, but also implies that you should make profits in increasing amounts as your growth slows down!
Now, Let's look at Gross Margins!
Gross Profit is the amount of money left after you deduct the cost of revenues from the revenues. You then divide the gross profit by the revenues to get the Gross margin. So, ideally, you want a business with less cost of revenues, which means higher gross margins. I use the following table as guidance for observing the gross margins of a SaaS business.
If you are looking at a stable/mature/moderate growth business you ideally want to see stable gross margins. Stable gross margins are a good indicator of high business quality.
If you are looking at a relatively new business with bad gross margins, you should observe the trend of gross margins over a couple of years and you should see a rising trend in the gross margins. They can increase their gross margins either by increasing their revenues and reaching economies of scale or by cutting costs and increasing prices. I prefer the first strategy of increasing revenues and reaching economies of scale. The second strategy of reducing costs leads to poor product quality and increasing prices may make the product too expensive! If you don't observe this pattern with bad gross margins, it might be best to avoid such a business as it will tend to be unsustainable over the long term.
An example of the above discussion is Samsara. If you look at their gross margins for the past 2-3 years you can see significant expansion to acceptable levels from unacceptable levels. Check out the image below.
A similar strategy is at play at Twilio, where they are on a journey to expand gross margins by increasingly selling higher-margin software products, most recent ones from their acquisition of Segment.
Lower gross margins can also indicate a higher degree of services/professional services being used for the implementation of SaaS which can be a positive or a negative depending on the business.
As gross margin increases, more money (i.e., gross profit) is available for reinvestment into a company’s operating expenses. A company with strong unit economics may choose to invest more cash into sales and marketing. A company with customers clamoring for additional modules/products may decide to invest more into R&D.
If you love this article and my work, I urge you to subscribe and share.
Thanks, take care.
Chet @ Modern Growth Investing